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U.S. Banks Stock Outlook - May 2012 - Industry Outlook

The U.S. banks appear well placed to perform relatively better
through the remainder of 2012 on lesser pressure on trading income,
uninterrupted expense control and a slowdown in the provision for
credit losses. At least the progress seen in the first quarter
gives this indication.

Though marked recovery of the bond and equity markets and
consequent revenue growth pushed the first quarter results a bit
higher than expected, core dynamics also showed strength.

Moreover, financial institutions are actively responding to every
legal and regulatory pressure. This has positioned the banks well
to encounter impending challenges.

However, the potency of the sector is not expected to return to its
pre-recession peak anytime soon. The economic intricacies may even
result in further disappointments in the upcoming quarters.

As the sector is undergoing a radical structural change, it will
witness headwinds in the near to mid-term. But entering the new
capital regime will ensure stability and security in the industry
over the long term.

Along with increasing earnings, a major recovery in the asset
markets, improving balance sheets and declining credit costs
promise growth for the U.S. banking sector, though at a
slower-than-normal pace. The dampening factors -- such as issues
related to the mortgage liabilities, asset-quality troubles, weak
loan demand, and the impact of tighter regulations and policy
changes -- are expected to remain tied to the fate of U.S. banks in
the upcoming quarters.

Looking back, after enduring overwhelming recessionary shocks, the
U.S. banking industry has gradually started recovering in the
recent years. Actually, financial support from the U.S. government
ultimately transformed into stability.

The government undertook several steps, including programs offering
capital injections and debt guarantees, to stabilize the financial
system. The banks are also working hard to address problem credit,
primarily in residential and commercial real estate. Commercial
real estate loan performance is expected to show strong improvement
over the year.

Earnings Growth Hard to Come By

Though reduced loss provisioning has helped the industry witness
strong earnings growth over the last couple of years, we don't
expect a significant pickup in upcoming earnings from provision
reductions, as the difference between loss provisions and
charge-offs is gradually reducing.

Banks will definitely try to look at other areas -- interest
income, non-interest income and operating costs -- to keep the
earnings growth intact, but we don't see any significant
opportunity with respect to the top line in the upcoming quarters.

Interest income will remain under pressure due to low interest
rates and sluggish loan growth. Though banks will try to cut
interest expenses and take additional risks to improve net interest
margins, the flattening of the yield curve will mar these efforts.

Ultimately, banks will be forced to face lower margins. In fact, if
the banks shift assets to longer maturities to keep net interest
margin strong, this could backfire once interest rates start
rising.

On the other hand, attempts to boost revenues through non-interest
sources -- introducing new fees, increasing minimum balances
requirement on deposit accounts and encouraging customers to use
credit cards -- could be hampered by ongoing regulatory actions, a
volatile global economy and soaring overhead. So, non-interest
income will be able to marginally contribute to total revenue.

Lower industry revenue will finally force these banks to cut costs
in order to stay afloat. As a result, banks will continue cutting
jobs and reducing the size of operations by selling non-core
assets. So, any cost-cutting measure will act as a defense.

Balance Sheet Recovery to Take Time

Since last year, banks have been trying to address asset-quality
troubles through the disposition of nonperforming assets. Also,
non-core asset shedding has become an industry trend, as banks have
no other alternative but to keep capital ratios above regulatory
requirements.

This non-core asset-selling, along with elevated charge-offs and
weak demand, will likely keep loan growth under pressure in the
near to mid-term. Moreover, heightened regulatory restrictions and
soaring delinquency rates will act as headwinds. However, banks
will experience steady deposit growth on the lack of low-risk
investment opportunities due to the global economic turmoil and
volatility in equity markets.

So we don't expect a significant strength in balance sheets to
return anytime soon.

Regulatory Threats to Growth

Following the latest recession, the regulatory environment has
become tougher and costlier for the U.S. banks. In the last several
quarters, banks had to face a number of regulatory requirements
under several laws, including the Dodd-Frank legislation, the
Durbin Amendment and the Volcker Rule.

Many other regulatory headwinds are expected to hinder growth in
the upcoming quarters as regulators focus on global alignment.
Though the aim is to meaningfully change the business models of
banks to make them self-sufficient over the longer term, the cost
of compliance will drag down profitability in the near to mid term.

While the implementation of the Basel III requirements will boost
minimum capital standards, there will be a short-term negative
impact on the financials of U.S. banks as they will have to adjust
their liquidity management processes. But a greater capital cushion
for the larger banks will add to their ability to withstand
internal and external shocks in the long run. However, banks will
get the time to strengthen their capital position as the Basel III
requirements will be gradually introduced during the 2013 to 2019
period.

Macroeconomic Headwinds

There are several macroeconomic factors that may weigh on the
profitability of the U.S. banks. The most crucial among these is
the uncertain outlook for the U.S. economy.

Though improved economic data -- such as rising consumer spending
and relatively lower unemployment -- point to optimism, the economy
has been witnessing a lot less momentum in the first half of 2012
than was anticipated earlier. Concerns have crept up in the
slothful stock market, exacerbated by ongoing concerns related to
the European debt crisis.

Though the U.S. commercial banks appear to have significant direct
and indirect exposure to Europe, the potential costs are expected
to be manageable. However, if the crisis extends further, there
will be significant impact on worldwide capital markets, and the
U.S. will not be left unscathed. Consequently, U.S. banks would
then face increased challenges.

On the other hand, the extremely low interest-rate environment is
another manifestation of this uncertain macro backdrop. Concerns
about European finances and soft U.S. growth prospects have made
treasury instruments the choice of safe asset class. As a result,
yields on benchmark treasury bonds have hovered at low levels.

Bank Failures Continue

While the financials of a few large banks continue to stabilize on
the back of the economic recovery, the industry is still on shaky
ground. The sector presents a picture similar to that of 2011, with
nagging issues like depressed home prices along with still-high
loan defaults and unemployment levels troubling such institutions.

The lingering economic uncertainty and its effects also weigh on
many banks. The need to absorb bad loans offered during the credit
explosion has made these banks susceptible to severe problems.

Furthermore, government efforts have not succeeded in restoring
lending activity at the banks. Lower lending will continue to hurt
margins, though the low interest rate environment should be
beneficial to banks with a liability-sensitive balance sheet.

Increasing loan losses on commercial real estate could trigger many
more bank failures in the upcoming years. However, considering the
moderate pace of bank failures, the 2012 number is not expected to
exceed the 2011 tally. From 2011 through 2015, bank failures are
estimated to cost The Federal Deposit Insurance Corporation (FDIC)
about $19 billion.

Eventually, the strong banks will continue to take advantage of
strategic opportunities, with the big fish eating the little ones.

Conclusion

Clearly, the banking system is still not out of the woods, as there
are several nagging issues that need to be addressed by the
government before shifting the strategy to growth.

However, before the banking sector regains investors' confidence,
it is likely to meet several disappointments on the way that would
partially offset positive developments.

OPPORTUNITIES

The regulatory requirement of focusing on banking institutions
toward higher-quality capital will help banks absorb big losses.
Though this would somewhat limit the profitability of banks, a
proper implementation would bring stability to the overall sector
and hopefully keep bank failures in check.

The financial system is going through massive deleveraging, and
banks in particular have lowered leverage. The implication for
banks is that profitability metrics (like returns on equity and
return on assets) will be under pressure.

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